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Standard costing and variance analysis

Chapter

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Syllabus Content

B - Standard Costing – 25% Manufacturing standards for material, labour, variable overhead and fixed overhead. Fixed overhead expenditure and volume variances. (Note: the subdivision of fixed overhead volume variance into capacity and efficiency elements will not be examined.) Price/rate and usage/efficiency variances for materials, labour and variable overhead. Further subdivision of total usage/efficiency variances into mix and yield components. (Note: The calculation of mix variances on both individual and average valuation bases is required.) Planning and operational variances. Sales price and sales revenue/margin volume variances (calculation of the latter on a unit basis related to revenue, gross margin and contribution margin). Application of these variances to all sectors, including professional services and retail analysis. Standards and variances in service industries, (including the phenomenon of "McDonaldization"), public services (e.g. Health), (including the use of "diagnostic related" or "reference" groups), and the professions (e.g. labour mix variances in audit work). Criticisms of standard costing in general and in advanced manufacturing environments in particular. Interpretation of variances: interrelationship, significance. Benchmarking.

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1.1 Introduction to standard costing A standard cost is a planned or forecast unit cost for a product or service, which is assumed to hold good given expected efficiency and cost levels within an organisation. It represents a target cost and is useful for planning, controlling and motivating within an organisation. Variance analysis is a budgetary control process, which compares standard or budgeted costs and revenues with the actual results of an organisation, in order to obtain information regarding any exceptions from budget, this information is also used to improve performance through control action e.g. correcting problems. Standard costing can be used for

• Budget preparation e.g. planning • Control through exception reporting e.g. performance measurement • Stock valuation • Cost bookkeeping. • Motivating staff

Under a standard costing system an organisation can value stock at standard cost, incorporating this within the ledger or cost accounts of the organisation, the budget or forecasts being a memorandum kept outside the ledger accounts. Types of standard

• Ideal Standard e.g. attained under the most favourable conditions with no allowance for any waste, scrap, idle time or downtime

• Attainable or Expected Standard e.g. what should be achieved with a reasonable level of effort given current efficiency and cost levels

• Loose Standard e.g. loosely set and easy to achieve • Basic Standard e.g. first standard ever used by the organisation and used as a basis or

yardstick for comparing current standards or monitoring trends over time • Historical Standards e.g. standards used historically in previous accounting periods

Critism of standard costing

Sometimes hard to define an ‘attainable standard’ Uncontrollability of performance within operations e.g. discounts lost due to the

reduction in the quantity ordered or seasonal price fluctuations within the period of appraisal

With more automation within operations, they become less valuable as information Feedback not feed forward control e.g. out of date information Revisions to standards may be too frequent to guide performance over time Standard costing is an internal not external control measure e.g. improvement also

needs to consider competition and customers Performance measurement would be inadequate as a process if the standard is wrong The reason or cause of the variance are sometimes overlooked or not investigated

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How to create a standard cost Standard material price

• Supplier quotations and estimates • Previous invoices/trends • Internet/websites of suppliers • Discounts for bulk purchases • Price seasonality • Cost to manufacture internally • Differences between the quality of

different material

Standard material usage

• Time/motion studies • Quality of material e.g. natural

wastage • Specification of standard product

manufactured • Operational wastage expected

Standard labour rate

• Market rate for grade/type of labour • Internal rates from HR department • Bonus schemes/piece work rates in

current use

Standard labour efficiency

• Idle time expected during operations • Time/motion studies • Skill/expertise of staff • Learning curve • Motivation of staff • Remuneration systems in place

Standard overhead rate

• Overhead absorption rates obtained

by dividing forecast overhead with an expected level of activity

• Review overhead • Understand fixed and variable

relationship with output, labour hours, machine hours or % of cost

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1.2 Methods for planning and control A fixed budget is a budget prepared on the basis of an single estimated production and sales volume. It does not mean it is never revised or changed, just fixed at a certain level of output sold and produced. This tends to be a form of budgeting for a service organisation where a high proportion of total cost is fixed, and therefore does not vary significantly, with the volume or activity of the service performed. Such a form of budgeting would be little use for control purposes, when comparing to actual results, if significant variable cost exists. A fixed budget provides details of costs, revenues or resource requirements for a single level of activity. Flexible budgets are prepared for many different sales and production quantities and can be used to plan more effectively for an organisation e.g. useful at the planning stage for ‘what if?’ analysis. Flexible budgeting recognises different cost behaviour patterns, that may rise or fall with the volume of production or sales and is a better system for control purposes. A flexible budgeting system based upon its budget set at the beginning of the period can be flexed to correspond to the actual activity volume of results for a period. When a budget is flexed it would give an appropriate level of revenue and costs as a yardstick to compare like for like to actual results, at the same activity level, meaningful variances can then be reported to the managers responsible for control purposes. Flexible budgeting

1. Useful at the planning stage (what if analysis) 2. Can be ‘flexed’ retrospectively and compared to actual results for control purposes

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Example 1.1 Butliness is a business that offers packaged holiday deals in 3 locations in the UK and as part of this service has a restaurant that serves many different meals and puddings through out the day to guests staying over in chalets on the holiday park. One such serving counter has been a major concern for the management, the ‘All week Sunday lunch’ counter, as it is expensive to run. The stand uses 2 staff on different shifts to cook and serve meals at the counter, the standard cost and price of the ‘Hungry man roast of the day’ is as follows: Standard cost information for 1 meal £ Per meal Chicken 0.3kg @ £2.50 per kg 0.75 Vegetables 0.5kg @ £0.50 per kg 0.25 Labour 15 mins @ £9.00/hr 2.25 Variable overhead 15 mins @ £2.00/hr 0.50 Fixed overhead 15 mins @ £20.00/hr 5.00 8.75 Standard profit 3.20 Selling price (included in packaged price) 11.95 The counter works on a 6-day shift (all week except Sunday) and the budget aims to sell 500 meals within week 43 the following actual information was obtained. Meals actually sold were 476 the revenue earned £5,688. Ingredients purchased Chicken Vegetables Purchased 180kg (£405) 250kg (£140) Used 165kg 220kg Chef wages for week 43 Hours paid 120 hours (wages paid £1,200) Hours worked 114 hours 6 hours were idle due to ovens failing on Tuesday afternoon Variable overhead £150 Fixed overhead £2,750 Produce the original budget, flexed budget based upon actual sales volume, and compare this to actual results in order to calculate any variances?

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Answer to Example 1.1 Budgets prepared for an organisation using absorption costing principles Original Flexed Actual Variances Production and sales 500 476 476 Sales 5,975 5,688 5,688 - Chicken 375 357 368 11(A) Veg 125 119 125 6 (A) Labour 1,125 1,071 1,200 129(A) Variable overhead 250 238 150 88(F) Fixed overhead 2,500 2,380 2,750 370(A) 4,375 4,165 4,593 428(A) Profit 1,600 1,523 1,095 428(A) Budgets prepared for an organisation using marginal costing principles Original Flexed Actual Variances Production and sales 500 476 476 Sales 5,975 5,688 5,688 - Chicken 375 357 368 11(A) Veg 125 119 125 6 (A) Labour 1,125 1,071 1,200 129(A) Variable overhead 250 238 150 88(F) 1,875 1,785 1,843 58(A) Contribution 4,100 3,903 3,845 58(A) Fixed overhead 2,500 2,500 2,750 250(A) Profit 1,600 1,403 1,095 308(A) Notes

• The £368 actual charge for Chicken is the actual cost less standard cost of closing stock e.g. (£405 less (15kg x £2.50))

• The £125 actual charge for Vegetables is the actual cost less standard cost of closing stock e.g. (£140 less (30kg x £0.50))

• The absorption costing company charges fixed overhead to the profit and loss account on the basis of £5.00 for every meal produced e.g. 476 meals x £5.00 per meal = £2,380, for this reason, when a budget is flexed, we prorate the budgeted fixed overhead, but never for marginal costing organisations, they do not charge or absorb fixed overhead in this manner.

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1.3 Variance analysis By comparing a flexed budget, which has been prepared using standard cost information to actual results, total variances can be calculated. These reconcilable differences between the two statements can then be sub-divided further, calculated, interpreted and used to correct problems within the organisation to stay on target through control action by management or employees. Variances can occur for the following reasons

• Inaccurate data when creating standards, producing the budget or compiling actual results

• A standard used which is either not realistic or perhaps out of date • Efficiency of how operations were undertaken by management or employees during

the period of assessment • Random or chance

Budgetary planning involves the production of budgets or forecasts using realistic standards for cost and efficiency levels. Budgetary control identifies areas of responsibility for management and is the process of regularly comparing actual results against budget or standards. Because the original budget would have forecast a different number of units produced or sold, when compared to actual units produced or sold, a ‘flexed budget’ would be prepared in order to compare costs and revenues on a like with like basis.

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Variance calculations

Sales price variance

Did sell (actual quantity sold x actual price) X Should sell (actual quantity sold x standard price) (X) Sales price variance X

Sales volume profit

variance

units Did sell (actual quantity sold) X Should sell (budget quantity sold) (X)

X x standard profit per unit* Sales volume profit variance X * Standard profit would be used if the organisation uses absorption costing methods, when using marginal costing methods, the standard contribution volume variance, rather than standard volume profit variance would be used. The proforma above would be the same however the difference in units above would be multiplied by the standard contribution per unit rather than standard profit per unit. There is also the calculation of the sales volume revenue variance units Did sell (actual quantity sold) X Should sell (budget quantity sold) (X)

X x standard price Sales volume revenue variance X This would be a calculation considered in isolation from an operating statement e.g. if an organisation wants to reconcile the difference between the original sales budget revenue and actual sales revenue achieved rather than profit or contribution.

Material price

variance

Did spend (actual quantity purchased x actual price) X Should spend (actual quantity purchased x standard price) (X) Material price variance X This variance calculation always uses the quantity of material actually purchased never used, if there is a difference between the two within a question.

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Material usage

variance

Kg/litresActual production did use X Actual production should use (actual production x standard usage) (X)

X x standard price Material usage variance X This variance calculation always uses the quantity of material actually used never purchased, if there is a difference between the two within a question.

Labour rate variance

Did spend (actual hours paid x actual rate) X Should spend (actual hours paid x standard rate) (X) Labour rate variance X This variance calculation always uses the actual hours paid for never hours worked if there is a difference between the two within a question.

Labour efficiency variance

Hours Actual production did take X Actual production should take (actual production x standard hours) (X)

X x standard rate Labour efficiency variance X This variance calculation always uses the actual hours worked never hours paid if there is a difference between the two within a question.

Labour idle time

variance

Hours Actual hours paid for X Actual hours worked (X) Idle time X x standard rate Labour idle time variance X Only applicable if there is idle time e.g. a difference between labour hours paid and worked.

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Variable overhead

expenditure variance

Did spend (actual hours worked x actual OH rate) X Should spend (actual hours worked x standard OH rate) (X) Variable overhead expenditure variance X Variable overhead expenditure within a question will be assumed to be driven by labour hours worked never paid if there is a difference between the two e.g. if production stops and staff are idle then no variable overhead should be incurred.

Variable overhead efficiency variance

Hours Actual production did take X Actual production should take (actual production x standard hours) (X)

X x standard overhead rate Variable overhead efficiency variance X This variance calculation always uses the actual hours worked never hours paid if there is a difference between the two within a question; notice the proforma is similar to the labour efficiency variance.

Fixed overhead

expenditure variance

Actual fixed overhead expenditure X Budgeted fixed overhead expenditure (X) Fixed overhead expenditure variance X

Fixed overhead volume

variance

units Did produce (actual quantity produced) X Should produce (budget quantity produced) (X)

X x overhead absorption rate (O.A.R) Fixed overhead volume variance X This variance calculation is only applicable if the organisation uses absorption costing, never when marginal costing, and is to do with the way the organisation charges the profit and loss account within the production fixed overhead control account.

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1.4 Fixed overhead variances further explained Traditional absorption costing takes the total budgeted fixed overhead for a period and divides by a budgeted (or normal) activity level e.g. units, in order to find the overhead absorption rate. This is a simple method of charging fixed overhead and allows fixed overhead to be allocated to products, jobs or work-in-progress Overhead absorption rate (OAR) = Budgeted production overhead

Normal/budget level of activity

At the end of the period, the overhead ‘absorbed’ or charged to production is compared to the actual production overhead incurred for the period. Any shortfall in overhead charged would be an ‘under absorption’ of production overhead (DR profit and loss account CR Production overhead control account). Any ‘over charge’ to the profit and loss account during a period would be an ‘over absorption’ of production overhead (CR profit and loss account DR Production overhead control account). The sum of the fixed overhead expenditure and volume variance would be equal to the under or over absorption, when sub-divided, explaining the two different causes as to how this occurred during a period e.g. under or over spent and/or under or over produced when compared to the original budget. The difference between absorption costing and marginal costing organisations, is that the marginal costing organisation makes no attempt to absorb or charge production overhead into a cost unit or the profit and loss account. It treats production overhead as a period cost only and does not absorb overhead, but rather charges it entirely to the profit and loss account for each period. With marginal costing organisations only the fixed overhead expenditure never the fixed overhead volume variance would be applicable within a question.

Actual production overhead Actual production (units) x O.A.R = Charge to W.I.P during the period

Production fixed overhead control account

XX

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Stock valuation under absorption and marginal costing systems It is also important to remember that marginal costing organisations would also value stock at variable production cost only never full production cost, when contrasted to an absorption costing company. Standard cost per unit: Direct costs of production Direct labour X Direct material X Direct variable production overhead X Total direct variable cost or total prime cost X Marginal costing stock valuation Indirect production overhead absorbed X Full production cost X Absorption costing stock valuation

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Example 1.2 Butliness is a business that offers packaged holiday deals in 3 locations in the UK and as part of this service has a restaurant that serves many different meals and puddings through out the day to guests staying over in chalets on the holiday park. One such serving counter has been a major concern for the management, the ‘All week Sunday lunch’ counter, as it is expensive to run. The stand uses 2 staff on different shifts to cook and serve meals at the counter, the standard cost and price of the ‘Hungry man roast of the day’ is as follows: Standard cost information for 1 meal

£ Per meal Chicken 0.3kg @ £2.50 per kg 0.75 Vegetables 0.5kg @ £0.50 per kg 0.25 Labour 15 mins @ £9.00/hr 2.25 Variable overhead 15 mins @ £2.00/hr 0.50 Fixed overhead 15 mins @ £20.00/hr 5.00 8.75 Standard profit 3.20 Selling price (included in packaged price) 11.95 The counter works on a 6-day shift (all week except Sunday) and the budget aims to sell 500 meals every week. During week 43 the following actual information was obtained. Meals actually sold were 476 the revenue earned £5,688. Ingredients purchased Chicken Vegetables Purchased 180kg (£405) 250kg (£140) Used 165kg 220kg Chef wages for week 43 Hours paid 120 hours (Wages paid £1,200) Hours worked 114 hours 6 hours were idle due to ovens failing on Tuesday afternoon Variable overhead £150 Fixed overhead £2,750 Prepare an operating statement for week 43 for both an absorption and marginal costing organisation, which reconciles any differences between actual results and budget?

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Example 1.3 – working backwards Butliness had a problem with the accountant during period 46; he left in a fume and took all the actual accounts information with him as revenge. You have been called in from a temping agency to sort out the mess. The following information has been provided to you. Operating statement for week 43 Budget 1,600 Sales volume variance 77(A) Flexed budget 1,523 Sales price variance 0 1,523 Cost variances F A Chicken price variance 45 Chicken usage variance 55 Vegetable price variance 15 Vegetable usage variance 9 Labour efficiency variance 45 Labour rate variance 120 Idle time variance 54 Variable overhead efficiency variance 10 Variable overhead expenditure variance 78 Fixed overhead expenditure variance 250 Fixed overhead volume variance 120 187 614 427(A) Actual profit 1,096 Standard cost information for 1 meal £ Per meal Chicken 0.3kg @ £2.50 per kg 0.75 Vegetables 0.5kg @ £0.50 per kg 0.25 Labour 15 mins @ £9.00/hr 2.25 Variable overhead 15 mins @ £2.00/hr 0.50 Fixed overhead 15 mins @ £20.00/hr 5.00 8.75 Standard profit 3.20 Selling price (included in packaged price) 11.95

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Additional information known

• Budgeted fixed overhead was £2,500 • Actual hours paid were 6 more than worked due to an electrical fault with the ovens • Closing stock for chicken and vegetables rose during this period by 15kg and 30kg

respectively. • Sales were the same as production during the week

You are required to

1. Calculate the actual production and sale of meals 2. Calculate actual hours worked for the chefs 3. Calculate the actual quantity of chicken purchased 4. Calculate the actual price paid for chicken 5. Calculate the actual variable overhead expenditure 6. Calculate the actual fixed overhead expenditure

Note: an alternative form of question would have been to provide you with actual information and the variances, asking you to calculate budgeted or standard cost information instead. The principle would be exactly the same as within this example.

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1.5 Mix and yield (or productivity) variances A material usage variance can be subdivided into a mix and yield variance where there exists two or more ingredients that can be substituted for one another. The sum of the material mix and yield variances will total the sum of the material usage variance. The same concept can also be applied to labour mix and yield variances, when one grade or skill of labour can be substituted for another, when making a particular product or completing a job. The labour efficiency variance in this case reanalysed further into the mix and yield variances, exactly in the same way as the material usage variance. Interpreting mix variances ‘individual valuation basis’ Actual output did use should use standard price variance (at std mix) Material/Labour A X kg/Hrs X kg/Hrs x £x = £x (F) Material/Labour B X kg/Hrs X kg/Hrs x £x = £x (A)

X kg/Hrs X kg/Hrs £x (A)

• If you use a quantity of material which is more than standard mix there would be an adverse variance

• If you use a quantity of material which is less than standard mix there would be a favourable variance

Interpreting mix variances ‘average valuation basis’ Actual output did use should use standard price variance (at std mix) less average price Material/Labour A X kg/Hrs X kg/Hrs x £x = £x (F) Material/Labour B X kg/Hrs X kg/Hrs x £x = £x (A)

X kg/Hrs X kg/Hrs £x (A)

• If you use a quantity of material which is more than standard mix and the material is more expensive than the average cost, there would be an adverse variance

• If you use a quantity of material which is more than standard mix and the material is less expensive than the average cost, there would be a favourable variance

• If you use a quantity of material which is less than standard mix and the material is more expensive than the average cost, there would be a favourable variance

• If you use a quantity of material which is less than standard mix and the material is less expensive than the average cost, there would be an adverse variance

Both totals of the individual and average valuation bases give the same answer; it is the analysis which makes up the total, where you would find the differences between the two methods.

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Interpreting yield (or productivity) variances Yield Actual material used or labour time did produce X Actual material used or labour time should produce X Over/(under) produced X x standard cost of one unit of output x £x £X (A)/(F) The sum of the material mix/labour mix and material/labour yield variances will be equal to the material usage/labour efficiency variance respectively. It is also worth noting that there can be an interdependent relationship between a mix and yield variance e.g. a higher skill mix of labour in substitute of a lower skill mix, would cause an adverse mix variance, but may also cause at the same time a favourable yield variance, due to greater experience and therefore efficiency by that type of labour. Lastly a word of caution favourable variances, especially when dealing with mix and yield do not necessarily mean you have improved the organisation e.g. more water and less flavouring would improve both mix and yield when making soft drinks, but do little to improve the quality of the drink being made.

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Example 1.4 Butliness also does a ‘deep pan cheesy and tomato pizza’ on one of it’s counters, the standard or budget cost and usage of the topping ingredients for one pizza are as follows £ 0.5kg Tomatoes @ £1.40 a kg 0.70 0.6kg Cheese @ £7.50 a kg 4.50 5.20 1.1kg ingredients will produce or yield a 1kg pizza (due to evaporation in the cooking process). On a Wednesday afternoon 60 pizzas were cooked (to the weight specified of 1.0 kg) and the following ingredients were used during the process; Tomatoes 28 kg £45.00 Cheese 40kg £270.00 Calculate the material usage, mix and yield variances for Butliness for this day? Note: two methods exist for calculation of the mix variance, the individual valuation and average valuation bases. Make sure you are familiar with both types of calculation.

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1.6 Investigating variances Statistical methods for interpretation Variances can be expressed relatively rather than absolutely, the variance is normally expressed as a percentage against the standard cost. In a past exam (old syllabus the examiner asked students to express material mix and yield variances, the deviations in weight rather than values, as a percentage of the standardised weight for the product being produced. From the answer of example 1.4 above this would have been calculated as Tomato ingredient – mix 3kg/31kg = 9.7% (F) Cheese ingredient – mix 3kg/37kg = 8.1% (A) Yield 1.8kg/61.8kg = 2.9% (A) These percentages could be plotted on a graph from one period to the next, which would provide managers with the following advantages.

Graphical presentation or percentages analysed over time allows easier interpretation and clearer understanding by managers

Presenting variances over time allows trends to be identified easier By working out percentages expressed against standard, it removes changes in

monetary size of the variance caused by changing activity levels, improving trend analysis

Example of a variance chart % Favourable 0 JAN FEB MAR APR Adverse

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Factors to consider before investigation

1. The size of it (materiality) 2. The general trend of it e.g. use of control charts for this 3. The type of standard that was used 4. Interdependence with other variances 5. The likelihood of identifying the cause of it 6. The likelihood that if a cause is found then it is controllable 7. The cost and benefits of correcting the cause 8. The cost of the investigation

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Example 1.5 Mr Chumney-Warner, the accountant that left Butliness, due to personal grievances against the organisation and has set up an audit practice, providing work to local business within the area. Even though being a service organisation, Mr Chumney-Warner recognises that variances can also be applied to such organisations. He has created a standard cost of an average audit, which normally takes a partner, semi-senior and junior together, 20 hours. Details of one standard audit £ Partner 3 hours @ £100 per hour 300 Semi-senior 5 hours @ £70 per hour 350 Junior 12 hours @ £30 per hour 360 1,010 During the period of February, time sheets recorded the following information. In total, 90 hours was logged as audit work, completing 5 audits during this period. The new junior that had been recruited was under allot of pressure, and did not cope well. This had meant the semi-senior had to be involved more in compliance work to improve the quality of audit files. Mr Chumney-Warner was pleased however that his time as a partner was used less because of the final quality of the audit files, due to more involvement from the semi-senior. Actual time recorded on audit work Partner 12 hours Semi-senior 40 hours Junior 38 hours 90 hours You have again been recruited from an agency as a temp, your first job apart from idle chit chat about working conditions at Butliness, is to produce labour mix and yield calculations for Mr Chumney-Warner, within an operating statement, for the period of February above. Your mix calculations to use both the average and individual bases of valuation.

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1.7 Planning and operational variances Planning variances are caused by the budget or standard at the planning stage being wrong. The budget and standard used would therefore need revising if your operational variances are to be more realistic. Operational variances are your normal variance calculations as learned earlier within this chapter, that is, assuming all planning errors within the budget have been adjusted for or removed and your standard used is realistic. Process of calculating planning variances

1. Calculate the planning variance and adjust the original budget within the operating statement for this, before any operational variances are calculated

2. Adjust the standard cost used in the budget from ex ante to ex post (revised) standard 3. Now that the original budget and standard cost has been adjusted, the operational

variances that would be effected by the adjustment, will give a more realistic standard.

The effect is to sub-divide a variance into 2 parts

1. The planning variance which is beyond the control of staff e.g. planning errors 2. The operational variances which may be within the control of staff

This allows better management information for control purposes Planning and operational variances are not alternatives to the conventional approach; they just produce a more detailed analysis. Further analysis of variances into groups e.g. planning which are to do with poor planning or inadequate standards used compared with actual true favourable or adverse operational variances, allow managers to be appraised truly on deviations they can control not those variances which are beyond their control. Advantages of planning variances

Highlight between variances which are controllable and uncontrollable Help motivate managers and staff Help use more realistic standards Give a fairer reflection of operational variances

However critism includes still the question of determining a ‘realistic standard’ in the first place and putting too much emphasis on ‘bad planning’ rather than ‘bad management’ and the analysis can be more time consuming and costly than the conventional approach.

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Example 1.6 Using the information from Example 1.2, how should Butliness deal with the variance calculations if you were told the following; due to salmonella scare across the country the price of chicken had fallen to £2 a kg this should have been reflected in the budget when it was completed, but was overlooked. Adjust standard cost Revised Standard cost information for 1 meal

£ Per meal

Chicken 0.3kg @ £2.00 per kg 0.60 Vegetables 0.5kg @ £0.50 per kg 0.25 Labour 15 mins @ £9.00/hr 2.25 Variable overhead 15 mins @ £2.00/hr 0.50 Fixed overhead 15 mins @ £20.00/hr 5.00 8.60 Standard profit 3.35 Selling price (included in packaged price) 11.95 Chicken price planning variance 500 meals should have cost (x 0.3kg x £2.00) according to new standard 300 500 meals should have cost (x 0.3kg x £2.50) according to old standard 375 75(F) Revise operational variances now because standard has changed 180kg did cost 405 180kg should cost (x revised standard £2 per kg) 360 45(A) 476 meals did use 165kg 476 meals should use (0.3kg per meal) 143kg 22kg Revised standard price x £2 per kg 44 (A) Notice the biggest effect of this analysis is that the operational price variance changes from £45 favourable to £45 adverse. This highlights that the purchasing of the chicken is not as keener price as it should have been e.g. better control information. The planning variance will be offset against the original budget, just before the offset of the sales volume variance within the operating statement.

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1.8 Machine expenditure and efficiency variances Such variances use the same method as labour rate, efficiency and idle time variances – so do not be afraid when it comes to rate, efficiency and idle time variances for machines. Example 1.7 In the bar at Butliness they produce a ‘banana extravaganza’ by using a machine blender (it has proved to be very popular). Standard processing time for every 50 half-pint glasses is 0.6 hours at £40 variable overhead per hour. During one hot summer week there was 42 hours of processing time at a total cost that week of £1,880, 1,900 pints were produced. Calculate the machine expenditure and efficiency variances for the machine? What if you were told that the machine has been replaced with a machine, which is 20% faster than the previous model, but this had not been reflected in the budget?

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1.9 Causes of variances Possible causes of the individual variances are:

• Different sources of supply.

• Unexpected general price increase.

• Alteration in quantity discounts.

• Alteration in exchange rates (imported goods)

• Substitution of a different grade of material

Material price variance

• Standard set at mid-year price so one would expect a favourable price variance for part of the year and an adverse variance for the rest of the year.

• Higher/lower incidence of scrap.

• Alteration to product design.

Material usage variance

• Substitution of a different grade of material.

• Unexpected national wage award.

• Overtime/bonus payments different from plan.

Wages rate variance

• Substitution of a different grade of labour.

• Improvement in methods or working conditions.

• Variations in unavoidable idle time.

• Introduction of incentive scheme.

Labour efficiency variance

• Substitution of a different grade of labour.

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• Unexpected price changes for overhead items.

Variable overhead variance

• Labour efficiency variances (see above).

• Changes in prices relating to fixed overhead items e.g. rent increase.

Fixed overhead expenditure variance

• Seasonal effects e.g. heat/light in winter. (This arises where the annual budget is divided into four equal quarters of thirteen equal four-weekly periods without allowances for seasonal factors. Over a whole year the seasonal effects would cancel out.)

• Change in production volume due to change in demand or alterations to stockholding policy.

• Changes in productivity of labour or machinery.

Fixed overhead volume

• Production lost through strikes etc.

• Unplanned price increase. Operating profit variance due to selling prices

• Unplanned price reduction e.g. to try and attract additional business.

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1.10 Benchmarking “Continuous, systematic process for evaluating the products, services and work processes of an organisation that are recognised as representing best practice, for the purpose of organisational improvement.” World-class organisations strive to obtain competitive advantage. This can be achieved by using benchmarking. This is the process of comparing your performance with that of another organisation considered to be the best in its class. Benchmarking

1. Internal. Compare an internal function to the best found elsewhere internally within the same organisation.

2. ‘Best practice’ or functional. Compare an internal function to that of the best, not necessarily an organisation in the same industry.

3. Competitive. Product/service features compared to that of firms/competition in the same industry.

4. Strategic. Compare yourself in terms of organisational structure and culture, mission statement and strategic choices made to the most successful market leader.

Performance dimensions to gain competitive advantage

• Quality e.g. aesthetics (imperative to organisations like Dior or Cartier), features, courtesy and friendliness of staff involved within the purchase stages within the organisation, accuracy of administration

• Speed/flexibility e.g. AA/RAC 24/7, parcel force ‘overnight’, Concorde gave fast transatlantic flights

• Cost e.g. if the organisation pursues cost leadership • Differentiation e.g. brand recognition for certain product features such as image,

reliability or functional Companies to be the very best must establish where customers perceive differences, set the very best standards to exceed, establish what the competition is doing and encourage, manage knowledge and ideas of staff to exceed standards set. The process would involve

1. Select what you want to benchmark/set objectives 2. Consider benefits against the cost of doing it 3. Assign responsibilities to a team 4. Identify potential partners/known leaders 5. Breakdown of processes to complete 6. Test and measure (observation, experimentation or investigation/interview) 7. Gather information 8. Gap analysis 9. Implement changes/programmes/communicate 10. Monitor and control 11. Repeat regularly

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Benefits of benchmarking

Better understanding of competition and customers needs Discourages complacency/improves business awareness of managers You learn from other organisations mistakes Don’t need to ‘re-invent the wheel’ Source of new ideas/faster awareness of innovation Fewer complaints and warranty claims Leaner more efficient organisation in terms of waste and reworks Customer satisfaction and brand loyalty in the long-term Efficiency and effectiveness of functions or processes improved within the

organisation Sales and profitability improved

Drawbacks of benchmarking

Deciding and documenting what needs to be benchmarked is time consuming Getting the information to actually do it maybe a problem Confidential information could be leaked Damn lies and ‘statistics’ Deciding who is the best in their class Keeping employees motivated, as standards once exceeded, will normally be raised

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1.11 McDonaldization Modern manufacturing questions the thought of whether standard costing still plays a valuable part when considering information for control purposes.

• Dynamic environments • Customisation/differentiation not homogenous products • Shorter product life-cycles • Automation • Higher concern for quality rather than efficiency

George Ritver within his book ‘The McDonaldization of Society’ listed the advantages of producing standard or homogenous products, the pinnacle comparison being McDonalds, with its fast food strategy of uniformity of operations and delivery on a global basis. A concept you will find within thousands of companies in the world, especially the larger corporations e.g. Audi or V/W Group incorporating hundreds of components, including the engine, within a large range of cars manufactured. Although surely you would understand such an idea better through the use of a ‘Big Mac’ right? Standardisation of machinery, uniforms and packaging e.g. sachets, drinking cups and paper bags. Automation of dispensers, cooking processes and staff… have a nice day! Food already pre-prepared before cooking e.g. cheese sliced, salads prepared, sauces all pre-packed and easy to open and serve. This is uniformity or standardisation. Some facts about McDonalds

• Started as a hot dog stand in 1939 by 2 brothers (Richard and Maurice McDonald) • 30,000 outlets in 119 countries • One of the first to end waiter service • Cut their menus down to a few standard and homogenous dishes for simplicity • Plates replaced with cardboard containers to save on washing up

Advantages of McDonaldization ‘standardisation reduces cost and improves efficiency’

Control e.g. easier to create a pre-defined standard as there is such uniformity within the specification of the products produced, also easier to manage, organise, train and control workers

Efficiency e.g. combined with specialisation it is the most efficient way of working within large organisations

Predictability e.g. customer always knows what they are buying, giving reassurance and brand recognition

Calculability e.g. quantitative not qualitative information so easier to interpret Proficiency of staff can be assessed more effectively

Such a philosophy and its advantages are similar to the classical school of management, but can have its disadvantages

Excessive specialisation of tasks e.g. work dull and boring Removes initiative of workers e.g. reduces innovation and creativity Boredom, frustration and de-motivation of workers

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1.12 Diagnostic related or reference groups (DRG) ‘can applied to a Big Mac’ Standard costing is and can be applied to service organisations such as the health service, accountancy practice or even retail. The diagnostic reference group or healthcare resource group is a system of classifying hundreds of different medical conditions within the health sector, as a basis of recognising that similar medical illnesses require essentially similar treatment or care. There are around 800 DRGs existing within the health service. This enables health service management to

• Standardise resources e.g. beds/wards/consultancy/medication • Standardise patient treatment e.g. specifications of how treatment applied • Standardise codes for insurance companies or standardise payments to the NHS or

other private health providers for payment or charges made Such standards can also be used by government to benchmark the performance and create league tables of those hospitals that complete treatments within standard times and costs and those that do not. The DRG approach also used to remunerate hospitals for each standard treatment they perform. Such a system is not without its critics, arguing that surely it is the qualitative factors in patient treatment more than the quantitative measures that are more important when it comes to patient care, and not every operation or treatment can be cured in a single best way. If payments are made to hospitals based on a standard amount or price, this could mean overzealous treatment of a patient causing overspending; this in itself could affect the level of patient care given. Characteristics of services

• Intangibility e.g. no material substance or physical existence of it when compared to a tangible good

• Legal ownership e.g. no physical evidence often exists, so you can never return it if it was faulty

• Instant perishability e.g. unlike goods, services cannot be stored • Heterogeneity e.g. each time the service is performed even to the same customer it

can be different each time, goods generally are homogenous • Inseparability e.g. cannot be separated from the person who provides it

It is for the above reasons, as well as the human influence in the quality and effectiveness of the service performed, when compared to manufacturing a product, that makes standard costing more difficult to apply within the service sector.

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Solutions to lecture examples

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Example 1.2 - absorption costing organisation Operating statement for week 43 Budget (500 x 3.20) 1,600 Sales volume variance (476-500 x 3.20) 77(A) Flexed budget for 476 meals 1,523 Sales price variance (476 x (£11.95-£11.95) 0 1,523 Cost variances F A Chicken price variance (180kg x 2.25-2.50) 45 Chicken usage variance (143-165 x 2.50) 55 Vegetable price variance (250kg x 0.50-0.56) 15 Vegetable usage variance (238kg-220kg x 0.50) 9 Labour efficiency variance (119-114 x £9) 45 Labour rate variance (120 x £10-£9) 120 Idle time variance (6 x £9) 54 Variable overhead efficiency variance (119-114 x £2) 10 Variable overhead expenditure variance (114 x £2-£1.32) 78 Fixed overhead expenditure variance (£2500-£2750) 250 Fixed overhead volume variance (476-500 x £5) 120 187 614 = 427(A) Actual profit* 1,096 * Proof Sales 5,688 Chicken 405 Closing stock (15kg x £2.50) (38) Vegetables 140 Closing stock (30kg x 50p) (15) Labour 1,200 V/OH 150 F/OH 2,750 (4,592) 1,096

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Example 1.2 - marginal costing organisation Operating statement for week 43 Budget (500 x 8.20) 4,100 Sales volume variance (476-500 x 8.20) 197(A) Flexed budget for 476 meals 3,903 Sales price variance (476 x (£11.95-£11.95) 0 3,903 Cost variances F A Chicken price variance (180kg x 2.25-2.50) 45 Chicken usage variance (143-165 x 2.50) 55 Vegetable price variance (250kg x 0.50-0.56) 15 Vegetable usage variance (238kg-220kg x 0.50) 9 Labour efficiency variance (119-114 x £9) 45 Labour rate variance (120 x £10-£9) 120 Idle time variance (6 x £9) 54 Variable overhead efficiency variance (119-114 x £2) 10 Variable overhead expenditure variance (114 x £2-£1.32) 78 187 244 = 57(A) Actual contribution 3,846 Budgeted fixed overhead 2,500 Fixed overhead expenditure variance (£2500-£2750) 250(A) Actual profit* 1,096 * Proof Sales 5,688 Chicken 405 Closing stock (15kg x £2.50) (38) Vegetables 140 Closing stock (30kg x 50p) (15) Labour 1,200 V/OH 150 (1,842) Contribution 3,846 F/OH (2,750) 1,096

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Example 1.3 Calculate the actual production and sale of meals Did sell 476 (balance figure) Should sell 500 (£2500 Budget F/OH divided by £5 F/OH) 24 Standard profit per meal x £3.20 77(A) Calculate actual hours worked for the chefs 476 meals did take 114 (balance figure) 476 meals should take (476 x 0.25 hrs) 119 5 Standard rate per hour x £9.00 per hour 45(F) Hours paid for would have been 114 worked plus 6 hours idle time = 120 hours Calculate the actual quantity of chicken purchased 476 meals did use 165 kg (balance figure) 476 meals should have used (x0.3kg) 143 kg 22 kg Standard price per kg x £2.50 55 (A) Calculate the actual price paid for chicken 165kg used as above + 15kg rise in closing stock levels = 180kg purchased. 180kg did cost 405 (balance figure) 180kg should cost (x £2.50 kg) 450 45(F) Calculate the actual variable overhead expenditure 114 hrs worked did cost 150 (balance figure) 114 hrs should have cost (x £2 per hour) 228 78(F) Calculate the actual fixed overhead expenditure Actual fixed overhead 2,750 (balance figure) Budget fixed overhead 2,500 250(A)

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Example 1.4 Usage variance 60kg pizza did use should use standard price variance Tomato 28kg 30kg x £1.40 = £2.80 (F) Cheese 40kg 36kg x £7.50 = £30.00 (A) £27.20 (A) Mix can be calculated by one of two ways First method (individual valuation bases) 60kg pizza did use should use standard price variance (W1) Tomato 28kg 31kg x £1.40 = £4.20 (F) Cheese 40kg 37kg x £7.50 = £22.50 (A)

68kg 68kg £18.30 (A)

(W1) 68kg ingredients x 0.5kg/1.1kg = 31kg of tomatoes you would have used had you kept to the mix 68kg ingredients x 0.6kg/1.1kg = 37kg of cheese you would have used had you kept to the mix Second method (average valuation bases) Weighted average cost of one Kg of ingredients (0.5kg/1.1kg x £1.40) + (0.6kg/1.1kg x £7.50) = £4.73 Within the mix (did use less should use) x (average standard cost less standard cost) = variance Thus if an actual mixed quantity is greater than the standard quantity mixed for this material, but this material costs less than average, then a favourable variance will result, as also would using less of a relatively more expensive ingredient, when compared to the average cost. Tomatoes 28kg-31kg= 3kg x £4.73-£1.40 = £10.00 (A) Cheese 40kg-37kg= 3kg x £4.73-£7.50 = £8.31 (A) £18.31 (A) For tomatoes 3kg used less than you should of but this costs less than the average cost, adverse. For cheese 3 kg used more than you should of which costs more than the average cost, adverse. Butliness have substituted a relatively less expensive ingredient for a more expensive one, hence both variances adverse.

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Example 1.4 – continued. Yield 68kg of cheese and tomato should yield (68kg/1.1kg per pizza) 61.8 68kg of cheese and tomato did yield 60.0 Under produced 1.8 x standard cost of one pizza average cost per kg £4.73 x 1.1kg/1.0kg x £5.20* £9.37 (A) *1.1KG INGREDIANT = 1.0KG OUTPUT THEREFORE THE COST OF ONE PIZZA SHOULD BE 1.1/1.0 X £4.73 AVERAGE COST PER KG.

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Example 1.5 Labour Mix calculation - individual valuation basis Actual hours Standard mix Standard hours Standard rate Partner 12 3 / 20 13.5 1.5 £100 150.00 (F) Semi-senior 40 5 / 20 22.5 -17.5 £70 -1225.00 (A) Junior 38 12 / 20 54.0 16 £30 480.00 (F) 90 20 / 20 90.0 0.0 -595.00 (A) Labour Mix calculation - average valuation basis Actual hours Standard hours Standard rate - Average rate Partner 12 13.5 1.5 £100 £50.50 -49.50 74.25 (F) Semi-senior 40 22.5 -17.5 £70 £50.50 -19.50 -341.25 (A) Junior 38 54.0 16 £30 £50.50 20.50 -328.00 (A) 90 90.0 0.0 -595.00 (A) W1 Average rate (3/20 x £100) + (5/20 x £70) + (12/20 x £30) = £50.50 Labour yield or productivity variance 90 hours did yield 5.0 audits 90 audits should yield (90 hours/20 hours an audit) 4.5 audits 0.5 audits x standard cost of an audit (£1,010) £505(F) Operating statement 5 audits should cost (based on standard mix of labour) 5 x £1,010 = £5,050 Labour mix variance £595 (A) Labour yield variance £505 (F) 5 audits did cost (assuming standard rates were correct e.g. no rate variance) (12 hours x £100) + (40 hours x £70) + (38 hours x £30) = £5,140 Worse off by £90, the semi-senior improving productivity, due to higher quality of work, however this cost the organisation £90 (adverse) labour efficiency variance due to the higher cost of using the semi-senior, shown within the mix variance.

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Example 1.7 Machine expenditure and efficiency variances Standard cost of 25 pints £40 x 0.6 hrs = £24 per 25 pints. Efficiency 1900 pints did take 42.0 hrs 1900 pints should take (1900/25 x 0.6 hrs) 45.6 hrs 3.6 hrs Standard cost per machine hour x £40 144(F) Expenditure 42 hrs did cost 1,880 42 hrs should cost (42 x £40) 1,680 200 (A) Operating statement Flexed budget based on actual output achieved Budget 1900/25 x £24 = 1,824 Efficiency 144(F) Expenditure 200(A) Actual 1,880

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Example 1.7 - continued What if you were told that the machine has been replaced with a machine, which is 20% faster than the previous model, but this had not been reflected in the budget? Revise standard 0.6hrs x 0.8(20% faster time!!) x £40 Planning variance 1900 pints should have taken according to old standard 46hrs 1900 pints should have taken according to new standard 36hrs 10 hrs x £40 400(F) Operational expenditure variance no change Operational efficiency variance (revised) 1900/25 x 0.6 hrs x 0.8 should take 36 hrs Did take 42 hrs 6 hrs x £40 240 (A) Operating statement Flexed budget based on actual output achieved Budget 1900/25 x £24 = 1824 Planning 400(F) Efficiency 240(A) Expenditure 200(A) Actual 1880 About £14 rounding difference above.